This is the fifth article in a five part series that reviews the Section 1042 Capital Gains Tax Deferral alternative with respect to ESOP structures. In this last installment we will briefly discuss how to potentially eliminate capital gains taxes on proceeds from the sale of a business and we will discuss the summary points on a C-Corp vs. S-Corp sale.
One of the more powerful uses of the Section 1042 capital gains tax deferral is the elimination of capital gains taxes in their entirety. This requires planning, but in certain circumstances, the seller may be able to entirely eliminate capital gains taxes on the sale of their business.
Elimination of Capital Gains Taxes under Section 1042
We mentioned earlier that the deferral of capital gains taxes using Section 1042 could be turned into the elimination of capital gains taxes in their entirety. This occurs when the seller holds the investment in QRP until death. At that time, the QRP passes on to the seller’s heirs with a step up in basis. As the basis in the assets is now equal to the value of the investments, there is no capital gain to tax and, therefore, no capital gains taxes due. Please note that the overall estate, including the QRP, may be subject to Federal or state estate taxes, unless some other exemption exists. Still, avoiding a 30% or more in capital gains tax remains attractive and offers significant savings.
C-Corp vs. S-Corp Sale and Section 1042
Under current law, the Section 1042 deferral is not available to sellers of S-Corp stock to an ESOP. If the seller believes there would be a significant benefit to the Section 1042 deferral, but the company is currently organized as an S-Corp, one option is to convert to C-Corp status and then sell to the ESOP. In doing so, the seller can then take advantage of the deferral. The potential downside to this strategy deals with the Federal income tax ramifications for the company.
An S-Corp is a pass-through entity with respect to Federal income taxes. What this means is that there is no Federal income tax at the corporate level. All taxable income is allocated to the owners of the business proportionate to their ownership percentage. An ESOP trust is a tax-exempt entity. When the trust owns 100% of an S-Corp’s stock, all income is attributable to it and there is no Federal income tax payable. This is not the case with a C-Corp ESOP structure. With a C-Corp ESOP structure, there is Federal income tax potentially payable at the corporate level, before any distributions are made to the trust or other shareholders. Thus, the traditional double taxation situation will apply.
This doesn’t mean the conversion to C-Corp status should be rejected out of hand. There is still the potential to minimize or eliminate taxable income at the corporate level through the deductibility of the payments made to the ESOP. A future blog entry will detail how it works.
In conclusion, the sale of all or part of a C-Corporation to an ESOP may provide an opportunity for the seller to defer or eliminate capital gains taxes on the sale. Structuring this type of a transaction requires planning and an advisor well versed in the requirements for successfully implementing these structures. At ButcherJoseph, we know ESOPs. Our principals have closed almost $2 billion in ESOP transactions over the last 12 years. More importantly to our clients, we are transaction agnostic. We look at all of the alternatives and present clients with the pros and cons of each option so they can make a fully informed decision as to the best option for them. Give us a call to discuss how our expertise can benefit you and your business.
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